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On-Demand Performance Bonds & Fronted Letters of Credit 

On-demand performance bonds and letters of credit are used to provide a financial guarantee that a contractor will live up to the terms of the contract and that work is completed in accordance with governing laws.

In specific industries, like energy, a project owner will require contractors to include bonds or letters of credit with their bids to guarantee they have the liquid assets to pay suppliers or to pay penalties if they do not complete the work they are contracted to produce. While they have many similarities, there are key differences and advantages between on-demand performance bonds and fronted letters of credit.

Letters of Credit & On Demand Performance Bonds Frequently Asked Questions

Every written letter of credit and bond have subtle differences in the wording. A letter of credit can be posted to guarantee a purely financial obligation, such as a loan, or a performance obligation, such as a contract, while the On-Demand Performance (or Payment) bond is posted to meet specific performance, payment, and liquidated damages obligations as defined in the underlying contracts. A bond cannot guarantee a loan or a financial hedge. From a balance sheet perspective, a letter of credit is a secured instrument that reduces access to capital and overall liquidity, while an ODP is an unsecured instrument that does not tie up capital and improves liquidity.
A number of obligations in the energy sector can be covered by an on-demand bond, including short and long-term tolling agreements, Independent System Operator (ISO) obligations, rail car lease obligations and commodity supply obligations, and many other obligations. 
While the cost of an on-demand bond is similar to letter of credit pricing, the primary benefit of an on-demand bond is the ROI of turning under-utilized capital into revenue generating funds.
One advantage of an on-demand bond for energy companies is that they do not tie up liquid assets. The company is free to invest those assets in other ways or use them for payroll or supplies. Costs for payment bonds are clear and defined, while a letter of credit may require additional terms and collateral requirements. Aside from requiring a cost to obtain the bond, another disadvantage is if a claim is paid on the performance bond, the surety will make the payment to the project owner on their behalf, but the company will have to pay back that money to the surety.
With an on-demand bond, there is a 100% cover that is callable 365 during the coverage period. Most ODP bonds are also callable in the event replacement collateral is not received should there be a non-renewal under a long term, evergreen contract; aligning with the same mechanics as a letter of credit.
Yes, some major ISOs have started to accept ODPs. However, only two North American ISOs currently accept bonds. Other forms of unsecured collateral are available for qualified candidates.
Yes, a number of major North American pipeline operators now accept on-demand bonds as an acceptable form of adequate assurance for industry standard commodity supply agreements. Because the contracts are bi-lateral, the acceptance review is much quicker. In addition, many of these entities use on demands for their own collateral optimization strategies.
Yes, Allianz Trade’s credit rating is superior to most banks providing letters of credit in the energy space, so this typically provides an upgrade for obilgees.
Yes, the Surety & Fidelity Association of America (SFAA) oversees on-demand bonds and ensures that best practices and standards are being followed.

Fronted Letters of Credit Frequently Asked Questions

A fronted letter of credit serves to replace assurance when a beneficiary/ obligee won’t accept an ODP directly, for a contract or transaction that would otherwise be eligible for a bond. 
A fronted letter of credit works by a bank partner posting the letter of credit on the principal/applicant/customer’s behalf and Allianz Trade providing a guarantee to the bank. Allianz Trade then holds the risk of the principal in normal due course. The beneficiary or obligee receives a standard letter of credit from a qualified bank satisfying collateral requirements; the principal/applicant/customer gets unsecured treatment from the instrument on their balance sheet.
No, fronted letters of credit can only be used to provide assurance to meet performance, payment, and liquidated damages to the obligations as defined in the underlying contracts, and to performance obligations as defined in the underlying contracts. Financial guarantees may not be secured.
We work exclusively with banks rated A- or better, that would qualify as an acceptable bank to all major energy industry participants.
Yes, there is an additional fee to the bank for facilitating the arrangement. The fee depends on which bank provides the fronting arrangement. Typically, the all in cost aligns favorably with average letter of credit costs.
Typically, it will take 2–3 weeks to review language and get approvals in place for a fronted letter of credit.

There are typically three reasons why a fronted letter of credit might be used:

  • The Counterparty and/or collateral beneficiary does not accept bonds and will only accept letters of credit.
  • The principal, applicant or customer wants to utilize the liquidity advantages associated with the ODP and the associated fee with fronting vs. straight surety is outweighed by working capital/revenue generating funds. In this instance, a fronted letter of credit offers greater economic benefit in comparison to a traditional letter of credit costs.

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